Working out your prices

If your business is to survive and prosper, getting your prices right is essential. Your prices must be high enough to cover your costs and turn a reasonable profit – while remaining appealing to customers.

This module also covers additional factors you need to consider before setting prices.

Covering your costs

Businesses have two types of costs:

1)
Variable costs (also known as direct costs) are the actual costs of your materials (if you are a manufacturer) or product (if you are a retailer). They are ‘variable’ because they are linked to volume. The more you make or sell, the higher your costs.
2)
Fixed costs (also known as overheads or indirect costs) include such things as rent, rates, wages, etc, which remain the same regardless of volume.

One of the most common reasons people underprice their products is failure to add up all their fixed costs.

Most businesses have many fixed costs. All of these must be accounted for when you price a new product or service.

Template

Overheads in a restaurant

This template shows common overheads for a restaurant (food and drink are classified as direct materials; chefs and waiting wages as direct labour). You can adapt this table to produce a spreadsheet for your fixed costs. If necessary, get help from an accountant to work out your likely monthly outgoings.

The four costing formulas

Once you have worked out your fixed costs, you can begin to work out your prices. Four methods are common:

1)
Cost-plus
2)
Job costing
3)
Process costing
4)
Service costing

This method is straightforward. Work out all costs associated with the product or service and add the amount of profit (usually expressed as a percentage of costs) you need to make.

This download provides an example you can adapt.

Template

Cost plus pricing model

This template provides an example you can adapt.

Using this method, you complete a job card for each job, detailing the direct materials and direct labour used. You then add a proportion of your fixed costs.

A job card will list the costs in each category:

•
Direct materials required for the job
•
Direct labour
•
Fixed costs applied (i.e. at £x per direct labour hour)

The pre-determined mark-up is then added to arrive at the price.

What follows is an example of a job card for a furniture manufacturer.

In this method, whether one or multiple products are made, the cost of the manufactured item is based on total cost of the batch.

Simply add up all costs and divide by the total number of units produced to get a cost per unit.

Then add mark-up.

For example:

To manufacture instant coffee, the raw coffee beans are brought into the factory, tested and roasted. They are then blended and the blend of roasted beans is percolated to obtain the pure coffee before being dried and packaged.

These processes are carried out in different departments within the factory. Each department becomes a cost centre and process costing is based on combining these costs.

Here’s an example of process costing for a coffee manufacturer:

Calculating the cost per 300kg of coffee

Template

Process costing

Adapt this Process costing template for your business.

When you sell services, knowledge and expertise, you are effectively selling time. If you're selling time, you can only deliver so many 'billable hours' per day/week/year.

The first key decision to make is – how many hours can you realistically sell in a year?

Follow this simple four-step process:

1)
Work out how many billable hours you can realistically sell
2)
Calculate the charge-out rate for your direct labour costs
3)
Allow for a proportion of your fixed costs
4)
These two costs added together will give you the required hourly charge-out rate

Step 1. Determine the chargeable hours in a year

Step 2 - Divide required income by chargeable hours.

Now you've worked out how many chargeable hours there are in the year, you can work out how much to charge for each hour.

For example, supposing you pay an employee £35,000 per year. Divide the income you wish to recover by the number of chargeable hours:

Employee's annual salary/Total chargeable hours = £ per hour

For example, £35,000/1,160 hours = £30.20 per hour

To recover the cost of the salary being paid to this employee, the staff member's time must be charged out at £30.20 per hour.

Template

Charge-out-rate

Calculate hourly rates with this charge-out-rate calculator.

Step 3. Calculate the charge-out rate for overheads.

Divide your overheads by total chargeable hours.

Total annual overheads/Total chargeable hours = £ per hour

For instance: £18,000/1160 hours = £15.50 per hour

Add together the charge for labour and fixed costs to get a true hourly cost.

Charge-out rate for overheads

This total charge will generate sufficient revenue to cover direct labour costs and administration overheads.

Now you’ve worked out your ‘ideal’ prices, it’s time for a reality check. Consider:

How much will a customer pay? Your customers may not be willing to pay what you expect or would like them to pay.

If you sell through others, you must consider the impact of the distributors' and retailers' mark-ups on the final sale price.

Consider what your competitors charge.

This doesn't mean you have to match or undercut them (there might be reasons why your offer is superior, in which case you can justify charging more), it's simply another consideration to ensure your pricing strategy is in line with customer expectations.

You may also need to take into account the standard pricing procedures used in your trade, industry or professional association.

For example, architects have standard ways of setting fees, depending on the level of service they offer clients.

If you don’t already know, find out what the pricing conventions are for your type of business.

You may find that the most effective pricing strategy for your new business is a mixture of the basic strategies outlined in this module.

Remember: the primary purpose is always to make sufficient profit.

Therefore, ensure your prices account for all direct costs, labour, fixed costs, margins for distributors and your profit margin.

Pricing is a something you get better at. Remember to re-visit and monitor your cost structures regularly to ensure your business remains successful and profitable. Get into the habit of regularly assessing your prices, to ensure you keep your profits maximised.